Thursday, January 10, 2019

How Bad Will Things Become? Part Nine: A Useful Not-Quite-Overruled Precedent

by Neil H. Buchanan

If there is ever another president of the United States, and if she is a Democrat, we will have a different kind of divided government, with a rabidly conservative Supreme Court set to do battle against its ideological foes in the political branches. Even if the Senate flips back to the Democrats, of course, Republicans will continue to engage in guerilla warfare by finding parliamentary tactics to gum up the works, but I want to focus on the Court's role as a barrier to future progress.

In my newest Verdict column, I consider an admittedly odd hypothetical question: If a future Congress and President agree to tax rich people more effectively than we currently do, will the Court's hyper-conservative bloc use a discredited precedent to invalidate that tax? My answer is, "Yes, they might." Here, I want to explore that discredited precedent a bit more, in order to return to the larger question of just how bad things might become under the solidified, stolen, extreme right-wing majority on the Supreme Court.

Today's Verdict column goes into detail regarding the tax analysis, and I encourage everyone to read the piece, but I can thumbnail the issue here. When a person buys a piece of property, such as shares of corporate stock, and the property goes up in value, the increase in the person's net worth is income. Just as I have income from labor if I am paid $100,000 in salary, I have income from capital if my property goes up in value by $100,000. In both cases, I have $100,000 more than I had at the beginning.

Under the U.S. tax system, however, only the salary earner will definitely be subject to the income tax in the year that he receives the income. The property owner will only be taxed on the gain if she "realizes" it, which means (setting aside some details) selling it for cash. If I buy a plot of land for $1million and sell it for $1,100,000, I have realized a $100,000 gain. Until I sell it, that $100,000 in income remains unrealized and untaxed -- but it is nonetheless income.

Leaving why this is unfair to one side, the doctrinal point is that the realization requirement is a policy choice by Congress. And plenty of people have argued over the decades that this was a bad policy choice, with many proposals on offer to cut back or eliminate the realization doctrine in the tax code. My question is whether the Roberts Court would tell Congress that the realization requirement is constitutionally required.

Ninety-nine years ago, the Court issued its decision in Eisner v. Macomber, one of the most confused and absurd bits of constitutional doctrine that one could ever hope to find. That 5-4 case is still taught in law schools as an entree into the realization doctrine, which is odd because everyone agrees that the majority's constitutional analysis is nonsense, and students only need to know that the tax statute requires realization before capital income can be taxed. (In 2014, I wrote a column discussing Justice Holmes's dissent in Macomber, which is interesting on its own terms but not pertinent here.)

The problem is the Macomber majority's actual reasoning. They claim that realization is constitutionally required because unrealized income is not income at all. The majority engages in a chain of reasoning that starts from the Sixteenth Amendment's statement that Congress can tax income "from whatever source derived." So far, so good. But things go badly wrong from there.

"Derived," the Court says, must mean that the income is available for the taxpayer's "separate use, benefit and disposal." The majority then leaps to the claim that income must be "severable" from the property that created it. Because an increase in the value of property does not sever the income from the capital, the majority reasons, it is apparently not derived from anything.

The Macomber majority thus says not only that realization of income
is required before taxation is permitted, but they actually argue that
unrealized income is not income at all. So "derived from" (the actual
constitutional language) becomes a hook to somehow require "separate
use," which becomes a requirement that income is income only if
"severed," which turns unrealized income into non-income. Weird.

The majority further argues, again quite bizarrely, that "enrichment through increase in value of capital investment is not income in any proper meaning of the term." But that is simply wrong. Any accountant or economist, or for that matter anyone who wants to make themselves financially better off, knows that being richer is the essence of receiving income.

In 1940, the Court all but overruled Macomber in Helvering v. Bruun. The key there, however, is in the words "all but." As I note in today's Verdict column: "The Bruun court thus subtly mocked its own precedent, limiting Macomber not merely to its facts but to the most trivial of those facts." It is subtle, but if one knows what the Court is actually saying, Bruun is quite honestly nerd-hilarious.

I am explicating the Macomber majority's strange reasoning here (which I did not do in the Verdict column) because that decision is a Lochner special. That is, in 1920 the Court was in the decades-long thrall of a pro-business majority that was inventing various constitutional doctrines to limit the power of the federal government. Protecting rich people's unrealized income from taxation was very much in keeping with the Lochner era's political underpinnings, and if words had to be tortured to get there, so be it.

In this series of columns, "How Bad Will Things Become?" (the last installment of which includes links to the entire series), I argued that the even-more-conservative new Roberts Court seems poised to revive Lochner-like jurisprudence. I am hardly the only person to make that argument, and there has long been a sub-movement among conservatives openly committed to bringing back Lochner.

Although this particular question -- whether the current Court would claim that the realization requirement is constitutionally required -- might never be tested (because even a Democratic Congress and president might not repeal realization), it is an intriguing example of how the Court's majority might proceed.

In particular, the Macomber situation presents us with the question of whether the Court's conservatives would bother to put a fig leaf over their reactionary judicial activism. After all, I have argued that these politicians in robes might be perfectly willing to (continue to) invent new doctrines, along the lines of the ahistorical Second Amendment revisionism that brought us Heller or the outright conjuring that brought us "the broccoli example" and the action/inaction requirement in the first Affordable Care Act case.

But I have also noted that these particular conservative justices seem keen to present themselves as deep intellectuals, and part of that pose includes linking their judicial activism to precedent, no matter how tenuously. Thus, because Macomber has never been formally overruled, Roberts et al. could easily dress up their motivated reasoning by reviving that case and using it to limit Congress's power to tax.

One might imagine that Macomber is particularly ill-suited to that purpose, however, because its reasoning is so ridiculously bad. But is it truly any worse than the Court's recent decisions in, say the Muslim ban case or Janus (the anti-union case from last term)? All these guys need is a way to say, "We are following the law, as we are required to do." And even embarrassing precedents can serve that purpose.

3 comments:

As to precedent, various accounts discuss the issue of overruling precedent given the Hyatt case just argued concerns just that question. "Justice" Kavanaugh flagged the issue as he did in the double jeopardy case, arguing stare decisis is part of original understanding & there is a strong test in place before you overrule.

The early 20th Century case cited is an interesting footnote in constitutional history. It is akin to the Slaughterhouse Cases and 1930s cases involving alcohol regulation where the Court deals with recently passed amendments.

I have a recollection of a proposal by the late Sen. Ted Kennedy, perhaps 3 decades ago, to treat as realized income increases at year end of a taxpayer's net worth (and perhaps decreases as losses) for tax purposes. As I recall this did not get much headway, perhaps because of Macomber constitutional issues? Fair market valuations of differing types of properties can be difficul t in determining such net worth Cash flow to pay taxes resulting from such may require the taxpayer to sell property that the taxpayer might not otherwise sell. Regardless of Macomber viability, it may be wise tax policy not to recognize such increases/losses as recognized for tax purposes. (Maybe borrowings on appreciated assets should be taxed in some manner.)

Regarding precedent, has Plessy's "separate but equal" been formally overturned in other than public school education?

1. Unrealized income is and has been for decades taxed at the business and individual level. All but the smallest businesses are required to account for taxable income on the accrual basis. So if a business sells $1 million worth of widgets in December of year 1 and collects the money in year 2 it pays taxes on the profits on the sale in year 1, not year 2 when it realizes the income.At the individual level a person who has constructive receipt of ordinary income recognizes that income for tax purposes when it is awarded, not when it is realized. The happens in many non-qualified deferred compensation plans.

2. The main reason why a portfolio is not 'marked to market' for tax purposes for both individuals and businesses is that it is simply not practical to do so. If an investment is not publicly traded it is very difficult, time consuming and expensive to obtain a valuation, and in some cases almost impossible because of the unique nature of some assets.

3. The escape of taxation on realized capital gains through the estate tax is worse than Mr. Buchanan explains. For example, let's take a person, call him Mitt who has $200 million in investments with a tax liability of $50 million from unrealized capital gains. Mitt wants the money but doesn't want to pay the tax, so he goes to the David Ricardo Tax Company for help. How can Mitt get a lot of the $200 million and not pay tax? Easy. Mitt borrows against the portfolio and spends the proceeds on his 15th home. He pays no tax on the borrowed funds. Eventually Mitt dies, his heir liquidate the portfolio and pay no income taxes on the huge gain and use the proceeds to pay off the debt. So Mitt gets his money and avoids taxes.